From the October 01, 2011 issue of Futures Magazine • Subscribe!

A tale of two crude oil markets

The vast majority of the world looks at two crude oils as the benchmarks for the majority of crude oils in the world. WTI is the signature U.S. crude for the CME Group while Brent serves that role for the IntercontinentalExchange. Both are high-quality crude oils, with WTI U.S.-based and Brent North Sea crude. From a quality perspective, WTI is a tad better than Brent and, all things being equal, WTI historically carries about $1 to $2 per barrel premium over Brent. The vast majority of crude oils sold in the world historically have been pegged to either WTI or Brent, depending on their proximity to the United States or Europe and/or their ultimate destination.

For years the spread was relatively predictable and somewhat straightforward to trade around a few key fundamental drivers. WTI is predominately a Midwest crude oil that mostly finds its way into what is referred to as the PADD 2 region of the United States with Cushing, Okla. (the delivery location for the Nymex WTI contract) a subset of PADD 2. Very simply, crude oil inventories and the value of the Brent/WTI spread were correlated directly (and still somewhat are). When crude oil inventories in PADD 2 are building, WTI tends to depreciate in value vs. Brent; when stocks are declining, the opposite relationship occurs. Over a long period of time inventories in PADD 2 have cycled through modestly long building periods followed by long destocking periods, thus providing an excellent backdrop to trade this spread.

Since the financial meltdown, inventories in PADD 2 have moved toward the upper end of normal and for the most part have remained at relatively high levels for an extended period of time (although they have been destocking of late), resulting in the spread moving out of its normal historical trading range and into an atypical relationship of Brent trading at a significant premium to WTI. An issue with PADD 2 is there are many pipelines to move crude oil into the region, but none to move surplus crude oil out of the region. So once inventories approach above normal levels, the only way to get them down is to increase refinery runs in the region. Unfortunately, with oil demand growth in the United States still languishing, refinery utilization rates have been mostly below normal and as such crude oil inventory destocking has been a slow process.

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